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SEIFFE:  The Fannie Mae/Freddie Mac Meltdown--Part 1

Wednesday, September 10, 2008 

By Ralf Seiffe

The Federal National Mortgage Association, better known as Fannie Mae and its younger sibling The Federal Home Loan Mortgage Corporation, also known as Freddie Mac, were placed into receivership by the federal government on Sunday.  The move has been expected for some time and represents the most aggressive action on the part of regulators and the Bush Administration to deal with the financial failure of these two government sponsored entities.  We will learn more about the plan’s specifics this week--initial reports are here--but what are the causes and implications of yet another federal bailout?  To understand these dynamics, it helps to take a look at the fundamentals of lending, markets and politics.

Today’s meltdown starts with the centrality of home ownership in America and credit it takes to buy a house with other people’s money.  It’s available to those with good credit and a down payment; anyone remembering the purchase of their first home is also likely to remember the agony of accumulating the down payment.  The character it takes to come up with that equity is one of the reasons lenders recognize that homeowners who are willing to offer their homes as collateral, are usually good risks.  Once funded, borrowers act to protect that equity and work hard to make sure they pay the mortgage on time to avoid foreclosure. 

Besides demonstrating character, equity also provides a cushion for the eventualities life presents from time-to-time.  Mortgage literally means an obligation that survives the borrower’s death by allowing the lender to extract the property’s intrinsic value.  Equity also protects against economic dislocations, personal difficulties such as illness and unemployment, local real estate conditions or other unforeseen events. 

As long as anyone can remember, the amount of equity that creates this good behavior and a cushion against uncertainties has been 20% of the market value of the property.  Said another way, it’s traditional to lend no more than 80% of the value of a home to avoid problems and <<financial institutions operate at their peril when they lend outside these traditional norms. 

Nevertheless, recent developments in the mortgage market have tested these standards with the notion of making loans with unusual, “creative” features. These included teaser rates, which allowed those without the capability to repay a market rate to qualify; for those that could not document their ability to repay (the so-called “Liar Loans”) and no-equity loans for those who had good credit but no cash. 

At the time these loans were made, they looked like good business to otherwise rational bankers.  After all, the Federal Reserve had crushed interest rates to all-time lows and, as a consequence, the value of real estate was exploding.  Rising real estate prices helped by a big exodus from the stock market and a new public attitude towards debt made one’s mortgage one’s financial friend.  At the margin, the basis for lending decisions moved from the ability of the borrower to repay to the ability of the markets to refinance. 

Next, consider the mission of Fannie and Freddie.  Fannie Mae was created during the Great Depression by the Roosevelt Administration to provide financial institutions with a source of liquidity.  What this means is that banks, savings and loans and other businesses that lend money to homeowners had a place to sell off the mortgages that would otherwise accumulate on their balance sheets.  This had at least two effects.  First, local financial institutions became more interested in lending to homeowners because they had an “out”.  Banks could sell their mortgages to a ready purchaser if their own financial condition changed and that materially decreased the risk of making long-term loans supported by short-term deposits.  Second, they could originate many more loans because selling the mortgages on their balance sheets replenished their cash.

Providing a way for banks to replenish their cash through the sale of mortgages is a valuable service.  It encouraged home ownership and a vibrant financial sector.  Since 1938, Fannie Mae dictated the sort of mortgages it would buy and generally, these standards reflected sound lending practices and size limits.  By insisting on time-proven lending standards, Fannie Mae operated as a low-risk, government sponsored enterprise that has allowed it to be involved in about one-half of all mortgages created in America. 

It’s my sense that when Fannie was created, its initial customers were prudent bankers who looked on the facility as a “last resort” for their own balance sheets.  Over time, the nature of the relationship changed from Fannie Mae being regarded as a safety valve to a functional source of capital.  This meant that banks--and even their mortgage broker customers--began to perceive the mortgage business as a fee generating business as opposed to an interest payment generating business.  Instead of holding the mortgages generated in their trading areas, their strategy was to sell them in the secondary markets and generate the origination fees from new mortgages as often as possible.    

Banking is a curious business in the sense that there is a reason that folks say one can get a loan from a bank only if a person already has the money.  The reason is that bankers have to live with their lending decisions and that naturally makes them cautious; they are most comfortable with borrowers who already have assets.  With the creation of a secondary market, living with one’s lending decisions is vacated.  When the object is to eventually sell the mortgage to the government--or at least a government sponsored enterprise--the bankers’ mindset changes from caution to a more opportunistic view.  This is the definition of a morale hazard and it has resulted in very loose lending standards.  Why worry about bad loans if the government is willing to take possibly bad loans off your hands?

Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader and Illinois Review.

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